The stochastic oscillator belongs to the family of momentum indicators which include the RSI and the MACD. Like the RSI, the stochastic oscillator was developed to preempt the strength of momentum in a stock, currency or commodity. It does this by taking the closing prices and applying this to the highs and lows of a specific trading period. The idea is that closing prices should represent the direction of the trend, therefore, when momentum begins to falter closing prices will begin to deviate from the prevailing trend.
The Stochastic oscillator is calculated using the high, low and most recent close to determine its value. The default setting for a stochastic oscillator is 14, meaning that it will take into consideration the previous 14 bars data in calculating its value. This can be manipulated to make the stochastic faster, or slower depending on whether the amount of bars it takes into consideration is decreased or increased. It is worth noting, however, that with fewer bars (and hence less data) the stochastic will become fas and react very sensitively to price action. With this in mind most traders prefer to maintain it at around 14, if only to make sure that they are all reading off the same page.
The stochastic oscilator operates on a scale of 0 to 100 which is intersected by a middle line at 50. It also defines areas of over-bought and over-sold values above 70 and below 30 respectively. When a stock, currency or commodity is considered over-sold the stochastic indicator will therefore sit below the value of 30. Many traders consider this a bullish signal that a correction in price maybe due and an increased probability that price may reverse. The Stochastic oscillator determines the level of the indicator by taking the high and low of the defined range and calculates where the latest close is in relation to this. When the indicator value is at 50, it means that the most recent close was right in the middle of this high-low range and therefore gives no indication of trend. However, when price closes in the top 30% of this range then the indicator will be pushed above 70, a signal that perhaps the market is becoming overheated.
Stochastics, similar to RSI, can also be used as a powerful divergence indicator. This is because it is a range-bound momentum indicator and, due to the fact that momentum precedes price, it has the ability to pre-empt changes in price direction. Many traders watch the stochastic oscillator for signals of divergence as, not only will they show a value in the extreme ranges of the indicators scale, but they will also show that price is not truly reflecting the underlying momentum of the market. It is in these situations that traders are given helpful foresight into the potential for price to reverse. The combination of a stock, currency or commodity being over-bought or over-sold and with evidence of divergence creates a high-probability scenario that the market is due a correction in the opposite direction.